Ebook Macroeconomics - Policy and practice (2nd edition): Part 2

(BQ) Part 2 book Macroeconomics - Policy and practice has contents: Aggregate supply and the phillips curve, the aggregate demand and supply model, macroeconomic policy and aggregate demand and supply analysis, the financial system and economic growth, the financial system and economic growth, fiscal policy and the government budget,...and other contents.

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11

Aggregate Supply and the

Phillips Curve

In the 1960s, the Kennedy and Johnson administrations followed the advice of Nobel Prize

winners Paul Samuelson and Robert Solow and pursued expansionary macroeconomic

policies to raise inflation a little bit, with the expectation that unemployment would be

permanently lower They were disappointed when, in the late 1960s and the 1970s,

inflation accelerated and yet the unemployment rate stayed uncomfortably high To

understand why they were wrong, we turn to a concept called the Phillips curve, which

describes the relationship between unemployment and inflation

In the preceding chapter, we derived the aggregate demand curve, which shows the

relationship between the inflation rate and the level of aggregate output when the goods

market is in equilibrium But how do we determine aggregate output and inflation? The

aggregate demand curve provides half of the story; we also need to factor in the

relation-ship between these two variables that is provided by the aggregate supply curve, which

we develop in this chapter

The Phillips curve provides the intuition for the aggregate supply curve First, we will

see how the economic profession’s views on the Phillips curve have evolved over time

and how this evolution has affected thinking about macroeconomic policy Then we can

use the Phillips curve to derive the aggregate supply curve, which will allow us to

com-plete our basic aggregate demand-aggregate supply framework for analyzing short-run

economic fluctuations in the next chapter

The Phillips Curve

In 1958, New Zealand economist A.W Phillips published a famous empirical paper

that examined the relationship between unemployment and wage growth in the United

Kingdom.1 For the years 1861 to 1957, he found that periods of low unemployment

were associated with rapid rises in wages, while periods of high unemployment were

characterized by low growth in wages Other economists soon extended his work to

many other countries Because inflation is more central to macroeconomic issues than

wage growth, they estimated the relationship between unemployment and inflation

The negative relationship between unemployment and inflation that they found in

many countries became known, naturally enough, as the Phillips curve.

Preview

1 A.W Phillips, “The Relationship Between Unemployment and the Rate of Change of Money Wages in the

United Kingdom, 1861–1957,” Economica 25 (November 1958): 283–299.

The idea behind the Phillips curve is quite intuitive When labor markets are tight—

that is, the unemployment rate is low—firms may have difficulty hiring qualified ers and may even have a hard time keeping their present employees Because of the shortage of workers in the labor market, firms will raise wages to attract needed work-ers and raise their prices at a more rapid rate

work-Phillips Curve Analysis in the 1960s

Because wage inflation feeds directly into overall inflation, in the 1960s, the Phillips curve became extremely popular as an explanation for inflation fluctuations because

it seemed to fit the data so well As shown in panel (a) of Figure 11.1’s plot of the U.S inflation rate against the unemployment rate from 1950 to 1969, there is a very clear negative relationship between unemployment and inflation The Phillips curve for that period seemed to imply that there is a long-run trade-off between unemployment and inflation—that is, policy makers can choose policies that lead to a higher rate of inflation

period in panel (a)

shows that a higher

inflation rate was

gen-erally associated with a

lower rate of

unemploy-ment Panel (b) shows

that after 1970, the

(a) Inflation and Unemployment, 1950–1969

Unemployment Rate (percent) 0%

and end up with a lower unemployment rate on a sustained basis This apparent off was very influential in policy circles in the 1960s, as we can see in the Policy and Practice case.

trade-The Friedman-Phelps Phillips Curve Analysis

In 1967 and 1968, Milton Friedman and Edmund Phelps pointed out a severe cal flaw in the Phillips curve analysis:3 it was inconsistent with the view that work-

theoreti-ers and firms care about real wages, the amount of real goods and services that wages can purchase, and not nominal wages Thus when workers and firms expect the price

level to rise, they will adjust nominal wages upward so that the real wage rate does not decrease In other words, wages and overall inflation will rise one-to-one with increases

in expected inflation, as well as respond to tightness in the labor market In addition, the Friedman-Phelps analysis suggested that in the long run the economy would reach the level of unemployment that would occur if all wages and prices were flexible, which

they called the natural rate of unemployment.4 The natural rate of unemployment is the

full-employment level of unemployment, because there will still be some ment even when wages and prices are flexible, as we will show in Chapter 20

unemploy-In 1960, Paul Samuelson and Robert Solow published a paper outlining how policy makers could exploit the Phillips curve trade-off The policy maker could choose between two competing goals—inflation and unemployment—and decide how high an inflation rate he or she would be willing to accept to attain a lower unemployment rate.2 Indeed, Samuelson and Solow even said that policy mak-

ers could achieve a “nonperfectionist” goal of a 3% unemployment rate at what they considered to be a tolerable inflation rate of 4–5% per year This thinking was influential during the Kennedy and then Johnson administrations, and contrib-

uted to the adoption of policies in the mid-1960s to stimulate the economy and bring the unemployment rate down to low levels At first these policies seemed to

be successful because the subsequent higher inflation rates were accompanied by

a fall in the unemployment rate However, the good times were not to last: from the late 1960s through the 1970s, inflation accelerated, yet the unemployment rate remained stubbornly high

The Phillips Curve Tradeoff and Macroeconomic Policy in the 1960s

Policy and Practice

2Paul A Samuelson and Robert M Solow, “Analytical Aspects of Anti-Inflation Policy,” American Economic

Review 50 (May 1960, Papers and Proceedings): 177–194.

3 Milton Friedman outlined his criticism of the Phillips curve in his 1967 presidential address to the American

Economic Association: Milton Friedman, “The Role of Monetary Policy,” American Economic Review 58

(1968): 1–17 Phelps’s reformulation of the Phillips curve analysis is given in Edmund Phelps, “Money-Wage

Dynamics and Labor-Market Equilibrium,” Journal of Political Economy 76 (July/August 1968, Part 2): 687–711.

4As we will discuss in Chapter 20, there will always be some unemployment that is either frictional

unem-ployment , unemployment that occurs because workers are searching for jobs, or structural unemployment,

unemployment that arises from a mismatch of skills with available jobs and is a structural feature of the labor markets Thus even when wages and prices are fully flexible, the natural rate of unemployment is above zero.

The Friedman-Phelps reasoning suggested a Phillips curve that we can write as follows:

where π represents inflation, πe expected inflation, U the unemployment rate, U n the ural rate of unemployment, and ω the sensitivity of inflation to U - U n The presence of the πe term explains why Equation 1 is also referred to as the expectations-augmented Phillips curve: it indicates that inflation is negatively related to the difference between

nat-the unemployment rate and nat-the natural rate of unemployment (U - U n), a measure of

tightness in the labor markets called the unemployment gap.

The expectations-augmented Phillips curve implies that long-run unemployment will be at the natural rate level, as Friedman and Phelps theorized Recognize that in the long run, expected inflation must gravitate to actual inflation, and Equation 1 therefore

indicates that U must be equal to U n.The Friedman-Phelps expectations-augmented version of the Phillips curve dis-plays no long-run trade-off between unemployment and inflation and is thus consistent with the classical dichotomy that indicates that changes in the price level should not affect the real economy To show this, Figure 11.2 presents the expectations-augmented

Phillips curve, marked as PC1, for a given expected inflation rate of 2% and a natural

rate of unemployment of 5% (PC1 goes through point 1 because Equation 1 indicates that when π = πe = 2%, U = U n = 5%, and its slope is -ω.) Suppose the economy

Mini-lecture

Unemployment Rate, U

Inflation Rate, p (percent)

LRPC

10%

U n = 5%

Step 1 A decrease in the

unemployment rate leads

to movement along PC1, raising the inflation rate.

Step 2 Expected inflation rises,

shifting the PC curve upward…

Step 3 until the Phillips

curve reaches PC3, where unemployment

is at the natural rate.

results in a higher

infla-tion rate for any given

level of expected

infla-tion If the economy

moves, due to a decline

is initially at point 1, where the unemployment rate is at the natural rate level of 5%, but then government policies to stimulate the economy cause the unemployment rate

to fall to 4%, a level below the natural rate level The economy then moves along PC1

to point 2, with inflation rising above 2%, say to 3.5% Expected inflation will then rise

as well, so the expectations-augmented Phillips curve will shift upward from PC1 to

PC2 Continued efforts to stimulate the economy and keep the unemployment rate at 4%, below the natural rate level, will cause further increases in the actual and expected inflation rates, causing the expectations-augmented Phillips curve to shift upward to

PC2 and to point 3, where inflation is now 5%

When will the expectations-augmented Phillips curve stop rising? Only when

unemployment is back at the natural rate level, that is, when U = U n = 5% Suppose this happens when inflation is at 10%; then expected inflation will also be at 10% because inflation has settled down to that level, with the expectations-augmented Phillips curve

at PC3 in Figure 11.2 The economy will now move to point 4, where π = πe = 10%, and

unemployment is at the natural rate, U = U n = 5% We thus see that in the long run, when the expectations-augmented Phillips curve is no longer shifting, the economy will

be at points like 1 and 4 The line connecting these points is thus the long-run Phillips

curve, which we mark as LRPC in Figure 11.2.

Figure 11.2 leads us to three important conclusions:

1 There is no long-run trade-off between unemployment and inflation

because, as the vertical long-run Phillips curve shows, a higher long-run

inflation rate is not associated with a lower level of unemployment

2 There is a short-run trade-off between unemployment and inflation

because with a given expected inflation rate, policy makers can attain a

lower unemployment rate at the expense of a somewhat higher than the

expected inflation rate, as at point 2 in Figure 11.2

3 There are two types of Phillips curves, long-run and short-run The

expectations-augmented Phillips curves—PC1, PC2, and PC3—are actually short-run Phillips curves: they are drawn for given values of expected in-

flation and will shift if deviations of unemployment from the natural rate

cause inflation and expected inflation to change

The Phillips Curve After the 1960s

As Figure 11.2 indicates, the expectations-augmented Phillips curve shows that the tive relationship between unemployment and inflation breaks down when the unem-ployment rate remains below the natural rate of unemployment for any extended period

nega-of time This prediction nega-of the Friedman and Phelps analysis turned out to be exactly right Starting in the 1970s, after a period of very low unemployment rates, the negative relationship between unemployment and inflation, which was so visible in the 1950s and 1960s, disappeared, as we can see in panel (b) of Figure 11.1 Not surprisingly, given the brilliance of Friedman and Phelps’s work, they were both awarded Nobel Prizes

The Modern Phillips Curve

With the sharp rise in oil prices in 1973 and 1979, inflation jumped up sharply (see panel (b) of Figure 11.1) and Phillips-curve theorists realized that they had to add one more feature to the expectations-augmented Phillips curve Recall from Chapter 3 that supply shocks are shocks to supply that change the amount of output an economy can

produce from the same amount of capital and labor These supply shocks translate

into price shocks, that is, shifts in inflation that are independent of tightness in labor

markets or expected inflation For example, when the supply of oil was restricted lowing the war between the Arab states and Israel in 1973, the price of oil more than quadrupled and firms had to raise prices to reflect their increased costs of produc-tion, thus driving up inflation Price shocks also could come from a rise in import

fol-prices or from cost-push shocks, in which workers push for wages higher than

pro-ductivity gains, thereby driving up costs and inflation Adding price shocks (ρ) to the expectations-augmented Phillips curve leads to the modern form of the short-run Phillips curve:

The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations

To complete our analysis of the Phillips curve, we need to understand how firms and households form expectations about inflation One simple way of thinking about how firms and households form their expectations about inflation is to assume that they do

so by looking at past inflation The simplest assumption is:

πe = π-1

where π-1 is the inflation rate in the previous period This form of expectations is

known as adaptive expectations or backward-looking expectations because

expectations are formed by looking at the past and therefore change only slowly over time.5 Substituting π-1 in for πe in Equation 2 yields the following short-run Phillips curve:

Inflation = Expected - ω * Unemployment + Price

This form of the Phillips curve has two advantages over the more general formulation

in Equation 2 First, it takes on a very simple mathematical form that is convenient to use Second, it provides two additional, realistic reasons why prices might be sticky

5An alternative, modern form of expectations makes use of the concept of rational expectations, where

expec-tations are formed using all available information, and so may react more quickly to new information We discuss rational expectations and their role in macroeconomic analysis in Chapter 21.

One reason comes from the view that inflation expectations adjust only slowly as tion trends change: inflation expectations are therefore sticky, which results in some inflation stickiness Another reason is that the presence of past inflation in the Phillips curve formulation can reflect the fact that some wage and price contracts might be backward-looking, that is, tied to past inflation trends, and so inflation might not fully adjust to changes in inflation expectations in the short run.

infla-There is, however, one important disadvantage of the adaptive-expectations form of the Phillips curve in Equation 3: it takes a very mechanical view of how inflation expec-tations are formed More sophisticated analysis of expectations formation has important implications for the conduct of macroeconomic policy, as we will see in Chapter 21 For the time being, we will make use of the simple form of the Phillips curve with adaptive expectations, keeping in mind that the π-1 term represents expected inflation

There is another convenient way of looking at the adaptive-expectations form of the Phillips curve By subtracting π-1 from both sides of Equation 3, we can rewrite it

as follows:

Written in this form, the Phillips curve indicates that a negative unemployment gap (tight labor market) causes the inflation rate to rise, that is, accelerate This relationship

is why the Equation 4 version of the Phillips curve is often referred to as an

accelera-tionist Phillips curve With this formulation, the term U n has another interpretation

Since inflation stops accelerating (changing) when the unemployment rate is at U n, we

also refer to this term as the non-accelerating inflation rate of unemployment or, more commonly, NAIRU.

The Aggregate Supply Curve

To complete our aggregate demand and supply model, we need to use our analysis of

the Phillips curve to derive an aggregate supply curve, which represents the

rela-tionship between the total quantity of output that firms are willing to produce and the inflation rate In the typical supply and demand analysis, we have only one supply curve, but this is not the case in the aggregate demand and supply framework We can translate the short- and long-run Phillips curves into short- and long-run aggre-gate supply curves We begin by examining the long-run aggregate supply curve We then derive the short-run aggregate supply curve and see how it shifts over time as the economy moves from the short run to the long run

Long-Run Aggregate Supply Curve

What determines the amount of output an economy can produce in the long run? As

we saw in Chapter 3, the key factors that determine long-run output are available nology, the amount of capital in the economy, and the amount of labor supplied in the long run, all of which are unrelated to the inflation rate The level of aggregate output

tech-supplied at the natural rate of unemployment is often referred to as the natural rate of

output However, the natural rate of output is more commonly referred to as potential

output, a term we encountered in Chapter 8, because it is the level of production that an

economy can sustain in the long run

The preceding reasoning indicates that because the long-run Phillips curve is tical, the long-run aggregate supply curve is vertical as well.6 Indeed, the long-run

ver-aggregate supply curve (LRAS) is vertical at potential output, denoted by Y P, say, at a quantity of $10 trillion, as drawn in Figure 11.3 Another way to think about the verti-cal long-run aggregate supply curve is that when wages and prices fully adjust, there

is a decoupling of the relationship between unemployment and inflation The classical dichotomy that we discussed in Chapters 5 and 8 indicates that what happens to the price level is divorced from what is happening in the real economy

Short-Run Aggregate Supply Curve

We can translate the modern Phillips curve into a short-run aggregate supply curve by replacing the unemployment gap 1U - U n 2 with the output gap we discussed in Chapter

8, the difference between output and potential output 1Y - YP2 To do this, we need to make use of a relationship between unemployment and aggregate output that was dis-covered by the economist Arthur Okun, once the chairman of the Council of Economic Advisors and later an economist with the Brookings Institution.7 Okun’s law describes

the negative relationship between the unemployment gap and the output gap

Figure 11.3

Long- and

Short-run Aggregate

Supply Curves

The amount of

aggre-gate output supplied at

any given inflation rate

is at potential output

in the long run, so that

the long-run aggregate

supply curve LRAS is

a vertical line at Y P

The short-run aggregate

supply curve, SRAS, is

upward sloping because

as Y rises relative to

Y P, labor markets get

tighter and inflation

rises SRAS intersects

LRAS at point 1, where

current inflation equals

the expected inflation.

Mini-lecture

Aggregate Output, Y ($ trillions)

Inflation Rate (percent)

7Arthur M Okun, “Potential GNP: Its Measurement and Significance,” in Proceeding of the Business and

Economics Section: American Statistical Association (Washington, D.C.: American Statistical Association, 1962),

pp 98–103; reprinted in Arthur M Okun, The Political Economy of Prosperity (Washington, D.C.: Brookings

Institution, 1970), pp 132–145.

6 Higher inflation can make for a less efficient economy and thus lead to a decline in the quantity of output actually produced In this case, the long-run aggregate supply curve might have a downward slope This insight does not change the basic lessons from aggregate demand and supply analysis in any significant way,

so for simplicity we will assume that the long-run aggregate supply curve is vertical.

Okun’s Law Okun’s law states that for each percentage point that output is above potential, the unemployment rate is one-half of a percentage point below the natural rate of unemployment Algebraically, it can be written as follows:8

Another way of thinking about Okun’s law is that a one percentage point increase

in output leads to a one-half percentage point decline in unemployment.9 Figure 11.4 shows that the evidence for Okun’s law is quite strong because there is a tight negative relationship between the percentage change in unemployment and real GDP growth

8The output gap, Y - Y P , in Okun’s law is most accurately expressed in percentage terms, so the units of Y and Y P would normally be in logs However, to keep the algebra simple in this and later chapters, we will

treat Y and Y P as levels and not logs both in the Okun’s law equation and in the short-run aggregate supply curve developed here.

9To see this algebraically, take the differences of Equation 5 and assume that U n remains constant (a able assumption because the natural rate of unemployment changes very slowly over time) Then,

reason-%∆U = -0.5 * 1%∆Y - %∆YP2 where %∆ indicates a percentage point change Since potential output grows at a fairly steady rate of around three percent a year, %∆YP = 3%, we can also write Okun’s law as follows:

%∆U = -0.5 * 1%∆Y - 32 or

%∆Y = 3 - 2.0 * %∆U Hence we can state Okun’s law in the following way: for every percentage point rise in output (real GDP), unemployment falls by one-half of a percentage point Alternatively, for every percentage point rise in unem- ployment, real GDP falls by two percentage points.

Figure 11.4

Okun’s Law,

1960–2013

The plot of the

percent-age point change in

the unemployment rate

versus the GDP growth

rate reveals a linear

Bureau of Labor Statistics

and Bureau of Economic

Analysis.

Why is the rate of decline in unemployment only half the rate of increase in put? When output rises, firms do not increase employment commensurately with the

out-increase in output, a phenomenon that is known as labor hoarding Rather, they work

employees harder, increasing their hours Furthermore, when the economy is ing, more people enter the labor force because job prospects are better, and so the unem-ployment rate does not fall by as much as employment increases

expand-Deriving The shOrT-run aggregaTe suPPLy Curve Using the Okun’s law

Equation 5 to substitute for U - U n in the short-run Phillips curve Equation 2 yields the following:

π = πe + 0.5 ω 1Y - Y P2 + ρReplacing 0.5 ω by γ, which describes the sensitivity of inflation to the output gap, pro-duces the short-run aggregate supply curve:

π = πe + γ 1Y - Y P2 + ρ (6) Inflation = Expected + γ * Output + Price

As we did in the Phillips curve analysis, we need to make an assumption about how expectations of inflation are formed, and again we will assume that they are adaptive so that πe = π-1 The short-run aggregate supply curve then becomes

Let’s assume that inflation last year was at 2%, so that π-1 = 2%, and that there was

no supply shock, so ρ = 0, and potential output Y P = $10 trillion Let’s also assume that the parameter γ, which describes how inflation responds to the output gap, equals 1.5 Then we can write the short-run aggregate supply curve as follows:

π = 2 + 1.5 1Y - 102 (8)

If Y is at potential output, Y P = $10 trillion, then the output gap, Y - 10, is zero Equation 8 then shows that at a level of output of $10 trillion, at which the output gap is zero, π = 2% We mark this level as point 1 on the short-run aggregate supply curve, AS, in Figure 11.3 on page 288 Note that the short-run supply curve intersects the long-run supply curve at the point at which the 2% current inflation rate equals 2% expected inflation.Now suppose that aggregate output rises to $11 trillion Because there is a positive

output gap (Y = $11 trillion 7 Y P = $10 trillion), Equation 8 indicates that inflation will rise above 2% to 3.5%, marked as point 2 The curve connecting points 1 and 2 is the

short-run aggregate supply curve, AS, and it is upward sloping The intuition behind this upward slope comes directly from Okun’s law and Phillips curve analysis When Y rises relative to Y P and Y 7 Y P, Okun’s law indicates that the unemployment rate falls With the labor market tighter, the short-run Phillips curve tells us that firms will raise their wages at a more rapid rate Firms will therefore also raise their prices at a more rapid rate, causing inflation to rise

Our discussion of how the short-run aggregate supply curve works indicates that there is a close relationship between the Phillips curve and the short-run aggregate supply curve, as is discussed in the box, “The Relationship of the Phillips Curve and the Short-Run Aggregate Supply Curve.”

sTiCky wages anD PriCes in The shOrT-run aggregaTe suPPLy Curve As

we saw earlier, the short-run Phillips curve implies that wages and prices are sticky Since we derived the short-run aggregate supply curve from the Phillips curve, sticky wages and prices are embodied in the short-run aggregate supply curve as well In the short-run aggregate supply curve, the more flexible wages and prices are, the more inflation responds to the output gap The value of γ would then be higher, which implies that the short-run aggregate supply curve is steeper When wages and prices are com-pletely flexible, γ becomes so large that the short-run aggregate supply curve becomes vertical and is identical to the long-run supply curve Completely flexible wages and prices put us back in a classical framework in which aggregate output is always at its potential level

Shifts in Aggregate Supply Curves

Now that we have derived the long-run and short-run aggregate supply curves, we can look at why each of these curves shifts

Shifts in the Long-Run Aggregate Supply Curve

The quantity of output supplied in the long run is determined by the production tion we examined in Chapter 3 The production function suggests three factors that cause potential output to change, producing a shift in the long-run aggregate sup-ply curve: 1) the total amount of capital in the economy, 2) the total amount of labor supplied in the economy, and 3) the available technology that puts labor and capital together to produce goods and services When any one of these three factors increases, potential output rises and the long-run aggregate supply curve shifts to the right from

func-LRAS1 to LRAS2, as in Figure 11.5

Because all three of these factors typically grow fairly steadily over time, Y P and the long-run aggregate supply curve will keep on shifting to the right at a steady pace

To keep things simple in diagrams in this and later chapters, when Y P is growing at a

steady rate, we represent Y P and the long-run aggregate supply curve as fixed

Another source of shifts in the long-run aggregate supply curve is changes in the natural rate of unemployment If the natural rate of unemployment declines, labor is being more heavily utilized, and so potential output will increase A decline in the natural

The derivation of Equation 6 illustrates that the

short-run aggregate supply curve is in reality just

a Phillips curve, but with the unemployment gap

replaced by an output gap Indeed, whenever we

talk about the short-run aggregate supply curve,

we can think of it as a Phillips curve However,

because output gaps and unemployment gaps are inversely related through Okun’s law, the negative relationship between inflation and the unemployment gap implies a positive relationship between inflation and the output gap

The Relationship of the Phillips Curve and the Short-Run

Aggregate Supply Curve

rate of unemployment thus shifts the long-run aggregate supply curve to the right from

LRAS1 to LRAS2, as in Figure 11.5 A rise in the natural rate of unemployment would have the opposite effect, shifting the long-run aggregate supply curve to the left In Chapter 20,

we discuss factors that cause the natural rate of unemployment to change

Shifts in the Short-Run Aggregate Supply Curve

The three terms on the right-hand side of Equation 6 for the short-run aggregate supply curve suggest that there are three factors that can shift the short-run aggregate supply curve: 1) expected inflation, 2) price shocks, and 3) a persistent output gap

exPeCTeD infLaTiOn Even though we have written expected inflation as π-1 in Equation 6, it is important to recognize that expected inflation might change for reasons that are unrelated to the past level of inflation For example, what if a newly appointed chairman of the Federal Reserve does not think that inflation is costly and so is will-ing to tolerate an inflation rate that is two percentage points higher? Households and firms will then expect that the Fed will pursue policies that will let inflation rise by two percentage points in the future In such a situation, expected inflation will jump by two percentage points and the short-run aggregate supply curve will shift upward and to

the left, from AS1 to AS2 in Figure 11.6

PriCe shOCks Suppose that energy prices suddenly shoot up because terrorists destroy a number of oil fields This supply restriction causes the price shock term in Equation 6 to jump up, and so the short-run aggregate supply curve will shift up and to

the left, from AS1 to AS2 in Figure 11.6

The long-run aggregate

supply curve shifts to

the right from LRAS1

to LRAS2 when there

is 1) an increase in the

total amount of capital

in the economy, 2) an

increase in the total

amount of labor

sup-plied in the economy,

movement in these

vari-ables shifts the LRAS

curve to the left.

Mini-lecture

Aggregate Output, Y ($ trillions)

Inflation Rate (percent)

capital, labor, technology

or a fall in the natural rate

of unemployment…

Step 2 shifts the

long-run aggregate supply curve to the right.

PersisTenT OuTPuT gaP We have already seen that a higher output gap leads to higher inflation, causing a movement along the short-run aggregate supply curve We represent this change by the movement from point 1 to point 2 on the initial short-run

aggregate supply curve AS1 in Figure 11.7 A persistent output gap, however, will cause the short-run aggregate supply curve to shift by affecting expected inflation To see this, consider what happens if the economy stays at $11 trillion 7 Y P = $10 trillion, so that the output gap remains persistently positive At point 2 on the initial short-run aggre-

gate supply curve AS1, output has risen to $11 trillion and inflation has risen from 2% to 3.5% Expected inflation in the next period will rise to 3.5%, and so the short-run aggre-

gate supply curve in the next period, AS2, will shift upward to

π = 3.5 + 1.5 1Y - 102 (9)

If output remains at $11 trillion at point 3, then Equation 9 tells us that inflation will rise

to 5% 3= 3.5% + 1.5 111 - 102%4 As the vertical arrow indicates, the short-run

aggre-gate supply curve will then shift upward to AS3 in the next period:

and Price Shocks

A rise in expected

infla-tion or a positive price

shock of two

percent-age points shifts the

Step 1 A rise in expected inflation

or a positive price shock…

trillion, the economy

moves along the AS1

curve from point 1 to

point 2, and inflation

rises to 3.5% If output

continues to remain at

$11 trillion, where the

output gap is positive,

the short-run aggregate

supply curve shifts up

to AS2 and then to AS3

The short-run aggregate

supply curve stops

shifting up when the

economy reaches point

4 on the short-run

aggre-gate supply curve, AS4 ,

Step 1 A positive output

gap leads to an increase

in inflation, causing movement from point 1

to point 2 on AS1.

Step 2.

A persistent positive output gap increases expected inflation, and shifts the aggregate supply curve upward…

Step 3 until aggregate output

returns to its potential level.

The same reasoning indicates that if aggregate output is kept below potential,

Y 6 Y P, for a sufficiently long period of time, then the short-run aggregate supply curve will shift downward and to the right This downward shift of the aggregate sup-ply curve will stop only when output returns to its potential level and the economy is back on the long-run aggregate supply curve

Now that we have a full understanding of aggregate supply curves and why they shift, we have all the building blocks necessary to develop the aggregate demand and supply analysis in the next chapter

slopes upward because as output rises relative

to potential output and labor markets tighten, inflation rises Assuming that expectations of inflation are adaptive so that πe = π-1, the short-run aggregate supply curve can be writ-ten as π = π-1 + γ 1Y - Y P2 + ρ

3 Four factors cause the long-run aggregate

sup-ply curve to shift to the right: 1) a rise in the total amount of capital in the economy, 2) a rise in the total amount of labor supplied in the economy, 3) better technology that generates more output from the same amount of capital and labor, and 4) a fall in the natural rate of unemployment Three factors cause the short-run aggregate sup-ply curve to shift upward: 1) a rise in expected inflation, 2) a price shock that leads to higher inflation, and 3) a positive output gap

Summary

1 The modern Phillips curve, π = πe ω 1U

-U n2 + ρ, indicates that inflation is negatively

correlated to the unemployment gap and is

positively correlated to expected inflation and

price shocks Although the long-run Phillips

curve is vertical—that is, unemployment is at

the natural rate of unemployment for any

infla-tion rate—the short-run Phillips curve, which is

determined for a given level of expected

infla-tion, is downward-sloping (a lower level of the

unemployment gap leads to higher inflation)

In other words, there is no long-run trade-off

between unemployment and inflation, but

there is a short-run trade-off

2 The long-run aggregate supply curve is vertical

at potential output, Y P The short-run

aggre-gate supply curve, π = πe + γ 1Y - Y P2 + ρ,

long-run Phillips curve, p 285natural rate of output, p 287natural rate of

unemployment, p 283

non-accelerating inflation rate of unemployment (NAIRU), p 287Okun’s law, p 288Phillips curve, p 281price shocks, p 286unemployment gap, p 284

of inflation? How do changes in each factor affect the short-run Phillips curve?

4 What are adaptive expectations? What justifies the assumption of adaptive expectations in Phillips curve analysis?

5 According to modern Phillips curve analysis, what factors determine the rate of inflation? How do changes in each factor affect the short-run Phillips curve?

The Phillips Curve

1 What basic relationship does the short-run

Phillips curve describe? What trade-offs does

this relationship seem to offer policy makers?

2 What basic relationship does the long-run

Phillips curve describe? How does this

rela-tionship differ from that described by the

short-run Phillips curve?

3 According to the expectations-augmented

Phillips curve, what factors determine the rate

review QueSTionS

All Questions are available in for practice or instructor assignment.

7 What is Okun’s law? How do we combine

it with Phillips curve analysis to derive the short-run aggregate supply curve?

The aggregate Supply Curve

6 What relationship does the aggregate supply

curve describe? How is this relationship depicted

with the long-run aggregate supply curve?

10 What causes the short-run aggregate supply

curve to shift?

Shifts in Aggregate Supply Curves

9 What causes the long-run aggregate supply

curve to shift?

The Phillips Curve

1 Plot the Phillips curve for Canada using the

following data Do you find evidence in favor

of the Phillips curve in your plot? Explain

12 10 8 6

2 The following graph shows inflation and

unemployment rates for Canada for the period

between 1970 and 2012 Does this graph show

evidence in favor of the Phillips curve?

8 Why does the short-run aggregate supply

curve slope upward?

3 Suppose that the expectations-augmented

Phillips curve is given by π = πe

-0.51U - U n2 If expected inflation is 3% and

the natural rate of unemployment is 5%,

com-plete the following:

a) Calculate the inflation rate according to the Phillips curve if unemployment is at 4%, 5%, and 6%

b) Plot the points from part (a) on a graph, and label the Phillips curve

during the fall of 2007 (from around 2.5% to 4.0%), unemployment did not change signifi-cantly (it even increased slightly) Explain the relationship between inflation and unemploy-ment in 2007 using the modern Phillips curve concept.

c) If wages were to become more rigid, what

would happen to the slope of this Phillips

curve?

4 During 2007, the U.S economy was hit by a

price shock when the price of oil increased

from around $60 per barrel to around $130 per

barrel by June 2008 While inflation increased

b) Calculate inflation when output is $8, $10, and $12 trillion, and plot the short-run aggregate supply curve

7 Using the expression for the short-run gate supply curve obtained in Problem 6, draw a new short-run aggregate supply curve

aggre-on the same graph if there is a price shock such that ρ = 2 Calculate inflation when out-put is $8, $10, and $12 trillion, respectively

8 Although Okun’s law holds for different countries, those with more flexible labor markets experience a higher response of unemployment to changes in GDP During the recent financial crisis, real GDP decreased

in the United States, Germany, and France Considering that the U.S labor market is more flexible than European labor markets, would you expect the same increase in unemploy-ment in these three countries?

The Aggregate Supply Curve

5 Suppose Okun’s law can be expressed

according to the following formula:

U - U n = -0.75 * 1Y - Y P2 Assuming that

potential output grows at a steady rate of 2.5%

and that the natural rate of unemployment

remains unchanged,

a) Calculate by how much unemployment

increases when real GDP decreases by one

percentage point

b) Calculate by how much real GDP

increases when unemployment decreases

by two percentage points

6 Assuming that Okun’s law is given by

U - U n = -0.75 * 1Y - Y P2 and that the

Phillips curve is given by π = πe - 0.6 *

1U - U n2 + ρ,

a) Obtain the short-run aggregate supply

curve if expectations are adaptive,

infla-tion was 3% last year, and potential output

is $10 trillion (assume ρ = 0)

b) Show graphically how use of the Internet

by job searchers and employers affects long-run aggregate supply

10 Some Federal Reserve officials have discussed

the possibility of increasing interest rates as a way of fighting potential increases in expected inflation If the public came to expect higher inflation rates in the future, what would be the effect on the short-run aggregate supply curve? Show your answer graphically

Shifts in Aggregate Supply Curves

9 Internet sites that allow people to post their

resumes online reduce the costs of job searches

and create opportunities for individuals looking

for jobs to be matched with potential employers

more quickly Assume that these advantages of

Internet job hunting reduce the average amount

of time people are unemployed

a) How do you think the Internet

has affected the natural rate of

unemployment?

1 Go to the St Louis Federal Reserve FRED

database, and find data on the

unemploy-ment rate (UNRATE) and a measure of

the price level, the personal consumption

expenditure price index (PCECTPI) For both

series, choose the frequency as “quarterly,”

and for the price index series, choose the

units as “Percent Change From Year Ago.”

Download both series onto a spreadsheet

DATA AnALySIS PRoBLEMS

The Problems update with real-time data in and are available for practice or instructor assignment.

c) Are your results in part (b) tent with an accelerationist view of the Phillips curve? Why or why not? Briefly explain.

3 (Advanced) Go to the St Louis Federal

Reserve FRED database, and find data

on potential output (GDPPOT), real GDP (GDPC1), a measure of the price level, the personal consumption expenditure price index (PCECTPI), and the University of Michigan inflation expectations measure, (MICH) For the price index series, choose

the units as “Percent Change From Year

Ago,” and for the inflation expectations

measure, choose the frequency as “Quarterly.”

Download all of the series onto a sheet Create a measure of the output gap, defined as the percentage difference between (actual) real GDP and potential GDP, for each quarter

spread-a) Estimate a version of the short-run aggregate supply curve using inflation

as the dependent (Y) variable and the

inflation expectations and output gap

measures as independent variables (X

variables) Use the transformed data above, from 2000 to the most recent data available, and run a linear regres-sion of these variables (You can do this

in Excel by using the Data Analysis ToolPak.)

b) Are the regression results consistent with a short-run aggregate supply curve model? Are the coefficient values sensible? Interpret the coefficients and briefly explain

c) How much predictive power does your estimated short-run aggregate supply curve have? Compare your results with those you obtained in Problem 1(b) above (if applicable) Explain the differ-ence in predictive power between the simple Phillips curve estimation and the short-run aggregate supply curve estimation you just created

d) Based on the most current data able and your regression results, by how much would inflation change if policy makers were to close the output gap?

avail-a) Create a scatter plot of the quarterly

unemployment and inflation data,

from 2000 to the most recent available

data Identify the point that represents

the most recent data on inflation and

unemployment Do the data support a

Phillips curve–like inverse relationship

between inflation and unemployment?

b) (Advanced) Using the unemployment

and inflation data above, create a fitted

(or regression) line of the data on the

scatter plot, using the unemployment

rate as the independent variable (Excel

has scatter plot layouts that you can

use to do this automatically, or you can

use Data Analysis with the ToolPak for

Excel.) Report the equation for the

fit-ted line

i Based on the fitted line, how much

would inflation have to change,

on average, in order to lower the unemployment rate by one percent-age point? What would be the most recent readings of inflation and the unemployment rate if that hap-pened?

ii How much predictive power does

your estimated Phillips curve have?

Why might the Friedman-Phelps or modern Phillips curves perform bet-ter? Briefly explain

2 Go to the St Louis Federal Reserve FRED

database, and find data on potential output

(GDPPOT), real GDP (GDPC1), and a

mea-sure of the price level, the personal

consump-tion expenditure price index (PCECTPI) For

the price index series, choose the units as

“Percent Change From Year Ago.” Download

the series onto a spreadsheet Create a

measure of the output gap, defined as the

percentage difference between (actual) real

GDP and potential GDP, for each quarter

a) Identify the periods, from 2000 to the

most recent data available, in which

output is consistently either above or

below potential (ignore an isolated

quarter that switches or is transitory)

b) For each of the periods identified in

part (a), calculate the average output

gap and the percentage point change in

the inflation rate from the beginning to

the end of the period

299      

In 2007 and 2008, the U.S economy encountered a perfect storm Oil prices more than

doubled, climbing to a record high of over $140 per barrel by July 2008 and sending

gasoline prices to over $4 per gallon At the same time, defaults by borrowers with weak

credit records in the subprime mortgage market seized up the financial markets and

caused consumer and business spending to decline The result was a severe economic

contraction at the same time that the inflation rate spiked

To understand how developments in 2007–2008 had such negative effects on the

economy, we now put together the aggregate demand and aggregate supply concepts

from the previous three chapters to develop a basic tool, aggregate demand and supply

analysis As with the supply and demand analysis from your earlier economics courses,

equilibrium occurs at the intersection of the aggregate demand and aggregate supply

curves

Aggregate demand and supply analysis is a powerful tool for studying short-run

fluc-tuations in the macroeconomy and analyzing how aggregate output and the inflation rate

are determined The analysis will help us interpret episodes in the business cycle such

as the recent severe recession in 2007–2009 In addition, in later chapters it will also

enable us to evaluate the debates on how economic policy should be conducted

Recap of the Aggregate Demand

and Supply Curves

As a starting point, let’s take stock of the building blocks for the aggregate demand

and aggregate supply model that we developed across Chapters 9–11 by revisiting the

aggregate demand and aggregate supply curves

The Aggregate Demand Curve

Recall that the aggregate demand curve indicates the relationship between the

infla-tion rate and the level of aggregate output when the goods market is in equilibrium,

that is, when aggregate output equals the total quantity of output demanded We

saw in Chapter 10 that the aggregate demand curve is downward sloping because a

rise in inflation leads the monetary policy authorities to raise real interest rates to keep

Preview

12

The Aggregate Demand

and Supply Model

inflation from spiraling out of control, which lowers planned expenditure (aggregate demand) and hence the equilibrium level of aggregate output The negative relation-ship between inflation and equilibrium output reflected in the downward sloping aggregate demand curve can be illustrated by the following schematic.

πc 1 rc 1 IT, CT, NXT 1 YT

Factors That Shift the Aggregate Demand Curve

As we saw in Chapter 10, seven basic factors that are exogenous to the model can shift the aggregate demand curve to a new position: 1) autonomous monetary policy, 2) gov-ernment purchases, 3) taxes, 4) autonomous net exports, 5) autonomous consumption expenditure, 6) autonomous investment, and 7) financial frictions (The use of the term

autonomous in the factors above sometimes confuses students, and so it is discussed in the box “What Does Autonomous Mean?”) As we examine each case, we ask what hap-

pens when each of these factors changes holding the inflation rate constant As a study aid, Table 12.1 summarizes the shifts in the aggregate demand curve from each of these seven factors

1 Autonomous monetary policy When the Federal Reserve autonomously

tightens monetary policy, it raises the autonomous component of the real

interest rate, r, that is unrelated to the current level of the inflation rate

The higher real interest rate at any given inflation rate leads to a higher real interest rate for financing investment projects, which leads to a decline

in investment spending and planned expenditure Higher real interest rates also lead to lower consumption spending and net exports Therefore the equilibrium level of aggregate output falls at any given inflation rate,

as the following schematic demonstrates

r c 1 IT, CT, NXT 1 YT

The aggregate demand curve therefore shifts to the left

FACToRS ThAT ShIFT The AggRegATe DeMAnD CURve

Note: Only increases (c) in the factors are shown The effect of decreases in the factors would be the opposite of those indicated in the “Shift” column.

cc

Sd

Table 12.1

2 Government purchases An increase in government purchases at any given

inflation rate adds directly to planned expenditure and hence the rium level of aggregate output rises:

equilib-Gc 1 Yc

As a result, the aggregate demand curve shifts to the right

3 Taxes At any given inflation rate, an increase in taxes lowers disposable

income, which will lead to lower consumption expenditure and planned expenditure, so that the equilibrium level of aggregate output falls:

T c 1 CT 1 YT

At any given inflation rate, the aggregate demand curve shifts to the left

4 Autonomous net exports An autonomous increase in net exports at any

given inflation rate adds directly to planned expenditure and so raises the equilibrium level of aggregate output:

NXc 1 Yc

Thus the aggregate demand curve shifts to the right

5 Autonomous consumption expenditure When consumers become more

op-timistic, autonomous consumption expenditure rises, and so they spend more at any given inflation rate Planned expenditure therefore rises, as does the equilibrium level of aggregate output:

Cc 1 Yc

The aggregate demand curve shifts to the right

6 Autonomous investment When businesses become more optimistic,

au-tonomous investment rises, and they spend more at any given inflation rate Planned investment increases and the equilibrium level of aggregate output rises

I c 1 Yc

The aggregate demand curve shifts to the right

When economists use the word autonomous, they

are referring to the component of the variable that

is exogenous (independent of other variables in the

model) For example, autonomous monetary policy

is the component of the real interest rate set by the

central bank that is unrelated to inflation or to any

other variable in the model Changes in mous components therefore are never associated with movements along a curve, but always with shifts in the curves Hence a change in autono-

autono-mous monetary policy shifts the MP and AD curves

but is never a movement along those curves

What Does Autonomous Mean?

7 Financial frictions The real interest rate for investments reflects not only

the real short-term interest rate on default-free debt instruments, r, that central banks set, but also financial frictions, denoted by f , which are

the extra costs of borrowing caused by barriers to efficient functioning

of financial markets When financial frictions increase, the real interest rate for investments increases, so that planned investment spending falls at any given inflation rate and the equilibrium level of aggregate output falls

f c 1 r i c 1 lT 1 YT

The aggregate demand curve shifts to the left

Short- and Long-Run Aggregate Supply Curves

As we saw in the preceding chapter, the aggregate supply curve, which indicates the relationship between the total quantity of output supplied and the inflation rate, comes

in short- and long-run varieties

Because in the long run wages and prices are fully flexible, the long-run aggregate supply curve is determined by the factors of production—labor and capital—and the technology that is available at the time, as well as the natural rate of unemployment

We typically assume that technology, the factors of production, and the natural rate

of unemployment are independent of the level of inflation As a result, the long-run

supply curve is vertical at the level of potential output, Y P: output higher or lower than this level would cause inflation to adjust until output returned to its potential level

Because wages and prices take time to adjust to economic conditions—as they are sticky—wages and prices will not fully adjust in the short run to keep output at its potential level Instead, output above potential, which means that labor and product markets are tight, will cause inflation to rise above its current level However, the rise will be limited in the short run, in contrast to the long run As a result, the short-run aggregate supply curve is upward sloping, but not vertical: as output rises relative to potential, inflation rises from its current level

Factors that Shift the Long-Run Aggregate Supply Curve

The long-run aggregate supply curve shifts when there are shocks to the natural rate of unemployment and technology or long-run changes in the amounts of labor or capital that affect the amount of output that the economy can produce Because technology

improves over time and factors of production accumulate too, Y P steadily but ally moves to the right (for simplicity, we ignore this gradual drift in our analysis)

gradu-Factors that Shift the Short-Run Aggregate Supply Curve

Three factors can shift the short-run aggregate supply curve: 1) expected inflation, 2) price shocks, and 3) a persistent output gap As a study aid, Table 12.2 summarizes the shifts in the short-run aggregate supply curve from each of these three factors

1 Expected inflation When expected inflation rises, workers and firms will

want to raise wages and prices more, causing inflation to rise Higher expected inflation thus leads to an upward and leftward shift in the short-run aggregate supply curve

2 Price shocks Negative supply shocks or workers pushing for higher wages

can cause firms to raise prices, which causes inflation to rise and shifts the short-run aggregate supply curve upward and to the left

3 Persistent output gap When output remains high relative to potential

out-put, the output gap is persistently positive 1Y 7 Y P2 Labor and product markets remain tight, which raises the current level of inflation from its initial level As long as the output gap persists, inflation will continue to rise next period, as will expected inflation The positive output gap leads to

an upward and leftward shift in the short-run aggregate supply curve

equilibrium in Aggregate Demand

and Supply Analysis

We can now put the aggregate demand and supply curves together to describe general equilibrium in the economy, when all markets are simultaneously in equilibrium at the

point where the quantity of aggregate output demanded equals the quantity of gate output supplied We represent general equilibrium graphically as the point where the aggregate demand curve intersects with the aggregate supply curve However, recall that we have two aggregate supply curves: one for the short run and one for the long run Consequently, in the context of aggregate supply and demand analysis, there are short-run and long-run equilibriums In this section, we illustrate equilibrium in the short and long runs In following sections we examine aggregate demand and aggre-gate supply shocks that lead to changes in equilibrium

FACToRS ThAT ShIFT The ShoRT-RUn AggRegATe SUPPLy CURve

Note: Only increases (c) in the factors are shown The effect of decreases in the factors would be the opposite of those indicated in the “Shift” column.

Table 12.2

1 A Web appendix to this chapter, found at www.pearsonhighered.com/mishkin, outlines a more general

algebraic analysis of the AD/AS model.

The AD curve in Figure 12.1 is the aggregate

demand curve we discussed in Chapter 10,

Y = 11 - 0.5π (1) The AS curve is the short-run aggregate sup-

ply curve described in Chapter 11, where the

inflation rate last period is 2%:

π = 2 + 1.5 1Y - 102 (2)

To show algebraically that equilibrium occurs

where Y = $10 trillion and π = 2%, we

substi-tute the expression for π from Equation 2 into

librium Y = $10 trillion Then substituting this

value of equilibrium output into the short-run aggregate supply Equation 2 yields the following:

π = 2 + 1.5 110 - 102 = 2

So the equilibrium inflation rate is 2%

Algebraic Determination of the Equilibrium

Output and Inflation Rate

curve AD and the

short-run aggregate supply

curve AS.

Aggregate Output, Y ($ trillions)

Inflation Rate (percent)

Y* = 10

AD

AS

E p* = 2%

Mini-lecture

Long-Run equilibrium

In supply and demand analysis, once we find the equilibrium at which the quantity demanded equals the quantity supplied, there is typically no need for additional analy-

sis In aggregate supply and demand analysis, however, that is not the case Even when

the quantity of aggregate output demanded equals the quantity supplied at the section of the aggregate demand curve and the short-run aggregate supply curve, if

inter-output differs from its potential level (Y* ≠ Y P), the equilibrium will move over time

To understand why, recall that if the current level of inflation changes from its initial level, the short-run aggregate supply curve will shift as wages and prices adjust to a new expected rate of inflation

Short-Run equilibrium over Time

We look at how the short-run equilibrium changes over time in response to two tions: when short-run equilibrium output is initially above potential output (the natu-ral rate of output) and when it is initially below potential output We will once again assume that potential output equals $10 trillion

situa-In panel (a) of Figure 12.2, the initial equilibrium occurs at point 1, the intersection

of the aggregate demand curve AD and the initial short-run aggregate supply curve

AS1 The level of equilibrium output, Y1 = $11 trillion, is greater than potential

out-put Y P = $10 trillion Unemployment is therefore less than its natural rate, and there

is excessive tightness in the labor market As the Phillips curve analysis in Chapter 11

indicates, tightness at Y1 = $11 trillion drives wages up and causes firms to raise their prices at a more rapid rate Inflation will then rise above the initial inflation rate, π1 Hence, next period, firms and households adjust their expectations and expected infla-tion is higher Wages and prices will then rise more rapidly, and the aggregate supply

curve shifts up and to the left from AS1 to AS2

The new short-run equilibrium at point 2 is a movement up the aggregate demand

curve and output falls to Y2 However, because aggregate output Y2 is still above

poten-tial output Y P, wages and prices increase at an even higher rate, so inflation again rises above its value last period Expected inflation rises further, eventually shifting

the aggregate supply curve up and to the left to AS3 The economy reaches long-run

equilibrium at point 3 on the vertical long-run aggregate supply curve (LRAS) at Y P Because output is at potential, there is no further pressure on inflation to rise and thus

no further tendency for the aggregate supply curve to shift

The movements in panel (a) indicate that the economy will not remain at a level

of output higher than potential output of $10 trillion over time Specifically, the run aggregate supply curve will shift to the left, raise the inflation rate, and cause the economy (equilibrium) to move upward along the aggregate demand curve until it comes to rest at a point on the long-run aggregate supply curve at potential output

The equilibrium will now move to point 2 and output rises to Y2 However, because

aggregate output Y2 is still below potential, Y P, inflation again declines from its value last

In both panels, the

initial short-run

equilib-rium is at point 1 at the

intersection of AD and

AS1 In panel (a), initial

short-run equilibrium is

above potential output,

the long-run

equilib-rium, so the short-run

aggregate supply curve

shifts upward until it

reaches AS3 , where

out-put returns to Y P

In panel (b), initial

short-run equilibrium is

below potential output,

so the short-run

aggre-gate supply curve shifts

downward until output

2

3

Inflation Rate, p

Step 1 Excess tightness

in the labor market increases expected inflation and shifts the

AS curve upward until…

Step 2 the economy returns

to the potential level of output.

Step 2 the economy returns

to the potential level of output.

Step 1 Excess slack

in the labor market decreases expected inflation and shifts the

AS curve downward until…

Self-Correcting Mechanism

Notice that in both panels of Figure 12.2, regardless of where output is initially, it returns

eventually to potential output, a feature we call the correcting mechanism The

self-correcting mechanism occurs because the short-run aggregate supply curve shifts up or down to restore the economy to full employment (aggregate output at potential) over time

Changes in equilibrium: Aggregate Demand Shocks

With an understanding of the distinction between the short-run and long-run

equi-libria, you are now ready to analyze what happens when there are demand shocks,

shocks that cause the aggregate demand curve to shift Figure 12.3 depicts the effect of

a rightward shift in the aggregate demand curve due to positive demand shocks caused

by one or more of the following:

■ An autonomous easing of monetary policy (rT, a lowering of the real interest rate at any given inflation rate)

■ An increase in government purchases 1Gc2

■ A decrease in taxes 1TT2

■ An increase in net exports 1NXc2

■ An increase in the willingness of consumers and businesses to spend because they become more optimistic 1Cc, Ic2

■ A decrease in financial frictions 1fT2Figure 12.3 shows the economy initially in long-run equilibrium at point 1, where

the initial aggregate demand curve AD1 intersects the short-run aggregate supply

Figure 12.3

Positive Demand

Shock

A positive demand

shock shifts the

aggre-gate demand curve

upward from AD1 to

AD2 and moves the

economy from point 1

to point 2, resulting in

higher inflation at 3.5%

and higher output of

$11 trillion Because

output is greater than

potential output, the

short-run aggregate

supply curve begins

to shift up, eventually

Step 4 the economy returns

to long-run equilibrium, with inflation permanently higher.

curve AS1 at Y P = $10 trillion and the inflation rate = 2% Suppose that the aggregate

demand curve has a rightward shift of $1.75 trillion to AD2 The economy moves up

the short-run aggregate supply curve AS1 to point 2, and both output and inflation rise. Algebraically, we can show that output rises to $11 trillion and inflation rises to 3.5% However, the economy will not remain at point 2 in the long run, because output

at $11 trillion is above potential output Inflation will rise, and the short-run

aggre-gate supply curve will eventually shift upward to AS3 The economy (equilibrium)

thus moves up the AD2 curve from point 2 to point 3, which is the point of long-run

equilibrium where inflation equals 5.5% and output returns to Y P = $10 trillion (The box, “Algebraic Determination of the Response to a Rightward Shift of the Aggregate Demand Curve,” derives these values of the equilibrium output and inflation rate alge-

braically.) Although the initial short-run effect of the rightward shift in the

aggre-gate demand curve is a rise in both inflation and output, the ultimate long-run effect is only a rise in inflation because output returns to its initial level at Y P.2

We begin our algebraic look at the increase in

aggregate demand the same way we did our

graphical analysis: suppose that the aggregate

demand curve shifts rightward by $1.75

tril-lion to AD2, which we represent in equation

form as Y = 12.75 - 0.5π Substituting in for

π = 2 + 1.5 1Y - 102 from the AS1 curve

yields the following:

shows that the equilibrium output at point 2 is

19.25>1.75 = $11 trillion Substituting this value

of equilibrium output into the short-run aggregate supply equation, π = 2 + 1.5 1Y - 102, yields

the following:

π = 2 + 1.5 111 - 102 = 3.5

so the equilibrium inflation rate is 3.5%

Long-run output goes to the potential level

of output, so Y = Y P = $10 trillion Substituting this value of output into the aggregate demand

curve AD2, Y = 12.75 - 0.5π,

10 = 12.75 - 0.5πwhich we can rewrite as

0.5π = 12.75 - 10 = 2.75Dividing both sides of the equation by 0.5 indicates that π = 5.5 Thus at the long-run equilibrium at point 3, the inflation rate is 5.5%

as in Figure 12.3

Algebraic Determination of the Response to a Rightward

Shift of the Aggregate Demand Curve

2 Note the analysis here assumes that each of these positive demand shocks occurs holding everything else

constant, the usual ceteris paribus assumption that is standard in supply and demand analysis Specifically

this means that the central bank is assumed to not be responding to demand shocks In Chapter 13, we relax this assumption and allow monetary policy makers to respond to these shocks As we will see, if monetary policy makers want to keep inflation from rising as a result of a positive demand shock, they will respond by autonomously tightening monetary policy and shifting up the monetary policy curve.

The Volcker Disinflation, 1980–1986

When Paul Volcker became the chairman of the Federal Reserve in August 1979, inflation had spun out of control and the inflation rate exceeded 10% Volcker was determined to get inflation down By early 1981, the Federal Reserve had raised the federal funds rate to over

Application

Figure 12.4

The Volcker

Disinflation

Panel (a) shows that

Fed Chairman Volcker’s

actions to decrease

inflation were

suc-cessful but costly:

the autonomous

mon-etary policy tightening

rates The data in panel

(b) supports this

analy-sis: note the decline

in the inflation rate

Step 3 which shifts

aggregate supply downward.

Step 2 lowering output

Step 4 Output increases

to potential output Y P and inflation declines further to p3.

(a) Aggregate Demand and Aggregate Supply Analysis

1980198119821983198419851986

Year

7.17.69.79.67.57.27.0

Unemployment Rate (%)

13.510.36.23.24.33.61.9

Inflation (Year to Year) (%) (b) Unemployment and Inflation, 1980–1986

Source: Economic Report

of the President.

Mini-lecture

We now turn to applying the aggregate demand and supply model to demand shocks, as a payoff for our hard work constructing the model Throughout the remain-der of this chapter, we will apply aggregate supply and demand analysis to a number of business cycle episodes, both in the United States and in foreign countries, over the last forty years To simplify our analysis, we always assume in all examples that aggregate output is initially at the level of potential output

Negative Demand Shocks, 2001–2004

In 2000, the U.S economy was expanding when it was hit by a series of negative shocks to aggregate demand

1 The “tech bubble” burst in March 2000 and the stock market fell sharply

2 The September 11, 2001, terrorist attacks weakened both consumer and business confidence

3 The Enron bankruptcy in late 2001 and other corporate accounting scandals in

2002 revealed that corporate financial data were not to be trusted, and so financial frictions increased Interest rates on corporate bonds rose as a result, making it more expensive for corporations to finance their investments

All these negative demand shocks led to a decline in household and business spending,

decreasing aggregate demand and shifting the aggregate demand curve to the left from AD1

to AD2 in panel (a) of Figure 12.5 At point 2, as our aggregate demand and supply analysis predicts, unemployment rose and inflation fell Panel (b) of Figure 12.5 shows that the unem-ployment rate, which had been at 4% in 2000, rose to 6% in 2003, while the annual rate of inflation fell from 3.4% in 2000 to 1.6% in 2002 With unemployment above the natural rate (estimated to be around 5%) and output below potential, the short-run aggregate supply

curve shifted downward to AS3, as we show in panel (a) of Figure 12.5 The economy moved

to point 3, with inflation falling, output rising back to potential output, and the ment rate returning to its natural rate level By 2004, the self-correcting mechanism feature

unemploy-of aggregate demand and supply analysis began to come into play, with the unemployment rate dropping back to 5.5% (see Figure 12.5 panel (b))

Application

20%, which led to a sharp increase in real interest rates Volcker was indeed successful in bringing inflation down, as panel (b) of Figure 12.4 indicates, with the inflation rate falling from 13.5% in 1980 to 1.9% in 1986 The decline in inflation came at a high cost: the economy experienced the worst recession up to that time since World War II, with the unemployment rate soaring to 9.7% in 1982

This outcome is exactly what our aggregate demand and supply analysis predicts The autonomous tightening of monetary policy decreased aggregate demand and shifted the

aggregate demand curve to the left from AD1 to AD2, as we show in panel (a) of Figure 12.4 The economy moved to point 2, indicating that unemployment would rise and inflation would fall With unemployment above the natural rate and output below potential, the

short-run aggregate supply curve shifted downward and to the right to AS3 The economy moved toward long-run equilibrium at point 3, with inflation continuing to fall, output ris-ing back to potential output, and the unemployment rate moving toward its natural rate level Figure 12.4 panel (b) shows that by 1986, the unemployment rate had fallen to 7% and the inflation rate was 1.9%, just as our aggregate demand and supply analysis predicts

The next period we will examine, 2001–2004, again illustrates negative demand shocks—this time, three at once

Figure 12.5

Negative Demand

Shocks, 2001–2004

Panel (a) shows that the

negative demand shocks

from 2001–2004

decreased consumption

expenditure and

invest-ment, shifting the

aggre-gate demand curve to

the left from AD1 to

AD2 The economy

moved to point 2, where

output fell,

unemploy-ment rose, and inflation

declined The large

neg-ative output gap when

output was less than

potential caused the

short-run aggregate

sup-ply curve to begin falling

to AS3 The economy

moved toward point 3,

where output would

return to potential:

infla-tion declines further to

π 3 and unemployment

falls back again to its

natural rate level of

around 5% The data in

panel (b) supports this

analysis, with inflation

declining to around 2%

and the unemployment

rate dropping back to

5.5% by 2004.

Aggregate Output, Y

20002001200220032004

Year

4.04.75.86.05.5

Unemployment Rate (%) Inflation (Year to Year) (%)

3.42.81.62.32.7

(b) Unemployment and Inflation, 2000–2004

Step 4 the economy returned

to long-run equilibrium, with inflation permanently lower.

(a) Aggregate Demand and Aggregate Supply Analysis

Source: Economic Report of the President.

Mini-lecture

Changes in equilibrium: Aggregate

Supply (Price) Shocks

The aggregate supply curve can shift from temporary supply (price) shocks in which the long-run aggregate supply curve does not shift, or from permanent supply shocks

in which the long-run aggregate supply curve does shift We look at these two types of supply shocks in turn

Temporary Supply Shocks

In our discussion of the Phillips curve in Chapter 11, we showed that inflation will change independent of tightness in the labor markets or of expected inflation

supply curve from AS1

to AS2 and the

econ-omy moves from point

1 to point 2, where

inflation increases to

3% and output declines

to $9 trillion Because

output is less than

potential, the

short-run aggregate supply

curve begins to shift

back down, eventually

returning to AS1 , where

the economy is again

at the initial long-run

equilibrium at point 1.

Step 1 A temporary

negative supply shock

shifts AS upward…

Step 2 increasing inflation

and decreasing output.

Aggregate Output, Y ($ trillions)

AS2

AS1

LRAS

Inflation Rate (percent)

when there is a temporary supply shock, such as a change in the supply of oil, that causes prices either to rise or to fall When the temporary shock involves a restric-

tion in supply, we refer to this type of supply shock as a negative (or unfavorable) supply shock, and it results in a rise in commodity prices (recall our discussion

of negative supply shocks related to technology, the natural environment, and energy in Chapter 3) Examples of temporary negative supply shocks are a disrup-tion in oil supplies, a rise in import prices when a currency declines in value, or

a cost-push shock from workers pushing for higher wages that outpace tivity growth, driving up costs and inflation When the supply shock involves an

produc-increase in supply, it is called a positive (or favorable) supply shock Temporary

posi-tive supply shocks can come from, for example, a particularly good harvest or a fall in import prices

To see how a temporary supply shock affects the economy using our aggregate ply and demand analysis, we start by assuming that the economy has output at its potential level of $10 trillion and inflation at 2% at point 1 Suppose that there is a tem-porary negative supply shock because of a war in the Middle East When the negative supply shock hits the economy and oil prices rise, the price shock term ρ causes infla-tion to rise above 2%, and the short-run aggregate supply curve shifts up and to the left

sup-from AS1 to AS2 in Figure 12.6

The economy will move up the aggregate demand curve from point 1 to point 2,

where inflation rises above 2% but aggregate output falls below $10 trillion We call a

situation of rising inflation but a falling level of aggregate output, as pictured in Figure

12.6, stagflation (a combination of the words stagnation and inflation) Because the

supply shock is temporary, productive capacity in the economy does not change, and

Negative Supply Shocks, 1973–1975 and 1978–1980

In 1973, the U.S economy was hit by a series of negative supply shocks:

1 As a result of the oil embargo stemming from the Arab–Israeli war of 1973, the nization of Petroleum Exporting Countries (OPEC) engineered a quadrupling of oil prices by restricting oil production

2 A series of crop failures throughout the world led to a sharp increase in food prices

3 The termination of U.S wage and price controls in 1973 and 1974 led to a push by workers to obtain wage increases that had been prevented by the controls

The triple thrust of these events shifted the short-run aggregate supply curve sharply

upward and to the left from AS1 to AS2 (as shown in panel (a) of Figure 12.7), and the omy moved to point 2 As the aggregate demand and supply diagram in Figure 12.7 predicts, both inflation and unemployment rose (inflation by 2.9 percentage points and unemploy-ment by 3.5 percentage points, as per panel (b) of Figure 12.7)

econ-The 1978–1980 period was almost an exact replay of the 1973–1975 period By 1978, the economy had just about fully recovered from the 1973–1975 supply shocks when poor harvests and a doubling of oil prices (a result of the overthrow of the Shah of Iran) led to another sharp upward and leftward shift of the short-run aggregate supply curve in 1979 The pattern predicted by Figure 12.7 played itself out again—inflation and unemployment both shot upward

Application

so Y P and the long-run aggregate supply curve LRAS remain stationary at $10 trillion

At point 2, output is therefore below its potential level (say at $9 trillion), so inflation falls and shifts the short-run aggregate supply curve back down to where it was ini-

tially at AS1 The economy (equilibrium) slides down the aggregate demand curve AD1

(assuming the aggregate demand curve remains in the same position) and returns to the long-run equilibrium at point 1, where output is again at $10 trillion and inflation

is at 2%

Although a temporary negative supply shock leads to an upward and ward shift in the short-run aggregate supply curve, which raises inflation and lowers output initially, the ultimate long-run effect is that output and inflation are unchanged.

left-A favorable (positive) supply shock—say an excellent harvest of wheat in the Midwest—moves all the curves in Figure 12.6 in the opposite direction and so has the

opposite effects A temporary positive supply shock shifts the short-run

aggre-gate supply curve downward and to the right, leading initially to a fall in tion and a rise in output In the long run, however, output and inflation will be unchanged (holding the aggregate demand curve constant).

infla-We now will once again apply the aggregate demand and supply model, this time

to temporary supply shocks We begin with negative supply shocks in 1973–1975 and 1978–1980 (Recall that we assume aggregate output is initially at the natural rate level.)

Permanent Supply Shocks

But what if the supply shock is not temporary? A permanent negative supply shock—such as an increase in ill-advised regulations that causes the economy to be less efficient, thereby reducing supply—would decrease potential output from, say,

Y P

1 = $10 trillion to Y P

2 = $8 trillion and shift the long-run aggregate supply curve to

the left from LRAS1 to LRAS2, as shown in Figure 12.8

Because the permanent supply shock will result in higher prices, there will be an immediate rise in inflation—say to 3%—from its previous level of 2%, and so the short-

run aggregate supply curve will shift up and to the left from AS1 to AS2 Although

output at point 2 has fallen to $9 trillion, it is still above Y P

2 = $8 trillion: the positive

Figure 12.7

Negative Supply

Shocks, 1973–1975

and 1978–1980

Panel (a) shows that

the temporary

nega-tive supply shocks in

1973 and 1979 led

to an upward shift in

the short-run aggregate

supply curve from AS1

to AS2 The economy

moved to point 2,

where output fell, and

both unemployment

and inflation rose

The data in panel (b)

support this analysis:

note the increase in

the inflation rate from

6.2% in 1973 to

9.1% in 1975 and the

increase in the

unem-ployment rate from

1980, while the

unem-ployment rate increased

Year

4.85.58.36.05.87.1

Unemployment Rate (%) Inflation (Year to Year) (%)

6.211.09.17.611.313.5

(b) Unemployment and Inflation, 1973–1975 and 1978–1980

Step 2 increasing inflation

and decreasing output.

(a) Aggregate Demand and Aggregate Supply Analysis

Step 1 A temporary negative

supply shock shifts AS upward…

Mini-lecture

output gap means that the aggregate supply curve will again shift up and to the left

It continues to do so until it reaches AS3 at the intersection of the aggregate demand

curve AD and the long-run aggregate supply curve LRAS2 Now, because output is at

Y P

2 = $8 trillion at point 3, the output gap is zero and, at an inflation rate of 4%, there is

no further upward pressure on inflation

Figure 12.8 generates the following result when we hold the aggregate demand

curve constant: a permanent negative supply shock leads initially to both a

decline in output and a rise in inflation However, in contrast to a temporary negative supply shock, in the long run a permanent negative supply shock, which results in a fall in potential output, leads to a permanent decline in out- put and a permanent rise in inflation.3

The opposite conclusion follows from a positive supply shock, for example, one caused by the development of new technology that raises productivity or an increase in

the supply of labor A permanent positive supply shock lowers inflation and raises

output both in the short run and the long run.

To this point, we have assumed that potential output Y P and hence the long-run aggregate supply curve are given However, over time, the potential level of output increases as a result of economic growth (which is the topic of Chapters 6 and 7) If

output and a

perma-nent rise in inflation,

as indicated by point

3, where inflation has

risen to 4% and output

has fallen to $8 trillion.

Step 1 A permanent negative

supply shock shifted the

LRAS curve leftward and

the AS curve upward…

Step 2 so the economy

returns to long-run equilibrium with output permanently lower and inflation permanently higher.

Mini-lecture

3 The discussion of the effects of permanent supply shocks assumes that monetary policy is not changing, so

that the monetary policy (MP) curve and the aggregate demand curve remain unchanged Monetary policy makers, however, might shift the MP curve if they want to shift the aggregate demand curve to keep inflation

at the same level See Chapter 13.

Positive Supply Shocks, 1995–1999

In February 1994, the Federal Reserve began to raise interest rates It believed the economy would be reaching potential output and the natural rate of unemployment in 1995, and it might become overheated thereafter, with output climbing above potential and inflation rising As we can see in panel (b) of Figure 12.9, however, the economy continued to grow rapidly, with the unemployment rate falling to below 5% in 1997 Yet inflation continued to fall, declining to around 1.6% in 1998

Can aggregate demand and supply analysis explain what happened? Two permanent positive supply shocks hit the economy in the late 1990s

1 Changes in the health care industry, such as the emergence of health maintenance ganizations (HMOs), reduced medical care costs substantially relative to other goods and services

2 The computer revolution finally began to impact productivity favorably, raising the potential growth rate of the economy (which journalists dubbed the “new economy”)

In addition, demographic factors, which we will discuss in Chapter 20, led to a fall in the natural rate of unemployment These factors led to a rightward shift in the long-run

aggregate supply curve to LRAS2 and a downward and rightward shift in the short-run

aggregate supply curve from AS1 to AS2, as shown in panel (a) of Figure 12.9 Aggregate output rose and unemployment fell, while inflation also declined

Application

the productive capacity of the economy is growing at a steady rate of 3% per year, for

example, every year Y P will grow by 3% and the long-run aggregate supply curve at

Y P will shift to the right by 3% To simplify the analysis, when Y P grows at a steady

rate, we represent Y P and the long-run aggregate supply curve as fixed in the gate demand and supply diagrams Keep in mind, however, that the level of aggregate output pictured in these diagrams is actually best thought of as the level of aggregate output relative to its normal rate of growth (trend)

aggre-The 1995–1999 period serves as an illustration of permanent positive supply shocks,

as the following application indicates

Conclusions

Aggregate demand and supply analysis yields the following important conclusions

1 The economy has a self-correcting mechanism that returns it to potential output and the natural rate of unemployment over time

2 A shift in the aggregate demand curve—caused by changes in mous monetary policy (changes in the real interest rate at any given inflation rate), government purchases, taxes, autonomous net exports,

autonomous consumption expenditure, autonomous investment, or financial frictions—affects output only in the short run and has no effect in the long run Furthermore, the initial change in inflation is lower than the long-run change in inflation when the short-run aggregate supply curve has fully adjusted.

3 A temporary supply shock affects output and inflation only in the short run and has no effect in the long run (holding the aggregate demand curve constant)

4 A permanent supply shock affects output and inflation both in the short and the long run

We close the section with one final application—this time with both supply and demand shocks at play—featuring the 2007–2009 financial crisis

Figure 12.9

Positive Supply

Shocks, 1995–1999

Panel (a) shows that

the positive supply

shocks from lower

health care costs and

the rise in productivity

from the computer

revo-lution led to a rightward

shift in the long-run

aggregate supply curve

from LRAS1 to LRAS2

and a downward shift in

the short-run aggregate

supply curve from AS1

to AS2 The economy

moved to point 2,

where aggregate output

rose, and

unemploy-ment and inflation fell

The data in panel (b)

support this analysis:

note that the

unem-ployment rate fell from

Year

5.65.44.94.54.2

Unemployment Rate (%) Inflation (Year to Year) (%)

2.83.02.31.62.2

(b) Unemployment and Inflation, 1995–1999

Step 2 and leads to

a permanent rise in output and a permanent decrease in inflation.

(a) Aggregate Demand and Aggregate Supply Analysis

Step 1 A permanent positive

supply shock shifts LRAS rightward and AS downward…

Mini-lecture

Source: Economic Report

of the President.

Negative Supply and Demand Shocks and the 2007–2009 Financial Crisis

We described the perfect storm of 2007–2009 in the chapter opener At the beginning of

2007, higher demand for oil from rapidly growing developing countries like China and India and the slowing of production in places like Mexico, Russia, and Nigeria drove up oil prices sharply from around the $60 per barrel level By the end of 2007, oil prices had

Application

Figure 12.10

Negative Supply and

Demand Shocks and

the 2007–2009 Crisis

Panel (a) shows that the

negative price shock

from the rise in the price

of oil shifted the

short-run aggregate supply

curve up from AS1 to

AS2 , while a negative

demand shock from the

financial crisis led to

a sharp contraction in

spending, resulting in

the aggregate demand

curve moving from AD1

to AD2 The economy

thus moved to point

2, where there was a

sharp contraction in

aggregate output, which

fell to Y2 , and a rise in

unemployment, while

inflation rose to π 2 The

fall in oil prices shifted

the short-run aggregate

supply curve back down

to AS1 , while the

deep-ening financial crisis

shifted the aggregate

demand curve to AD3

As a result, the economy

moved to point 3, where

inflation fell to π 3 and

output to Y3 The data

in panel (b) support this

analysis: note that the

unemployment rate rose

Unemployment Rate (%) Inflation (Year to Year) (%)

2.54.15.00.1–1.22.8

(b) Unemployment and Inflation During the Perfect Storm of 2007–2009

Step 1 A negative supply

shock shifted AS upward

and a negative demand

shock shifted AD leftward…

Aggregate Output, Y

Inflation Rate, p

AD2

Mini-lecture

Source: Economic Report of the President.

AD/AS Analysis of Foreign Business Cycle episodes

Our aggregate demand and supply analysis also can help us understand business cycle episodes in foreign countries Here we look at two: the business cycle experience of the United Kingdom during the 2007–2009 financial crisis and the quite different experi-ence of China during the same period

risen to $100 per barrel, and they reached a peak of over $140 per barrel in July 2008 The run up of oil prices, along with increases in other commodity prices, led to a nega-tive supply shock that shifted the short-run aggregate supply curve (shown in panel

(a) of Figure 12.10) sharply upward from AS1 to AS2 To make matters worse, a financial crisis hit the economy starting in August 2007, causing a sharp increase in financial fric-tions, which led to contraction in both household and business spending (more on this

in Chapter 15) This negative demand shock shifted the aggregate demand curve to the

left from AD1 to AD2 (see panel (a) of Figure 12.10) and moved the economy to point 2 These shocks led to a rise in the unemployment rate, a rise in the inflation rate, and a decline in output, as point 2 indicates As our aggregate demand and supply analysis predicts, this perfect storm of negative shocks led to a recession starting in December

2007, with the unemployment rate rising from the 4.6% level in 2006 and 2007 to 5.5%

by June 2008, and with the inflation rate rising from 2.5% in 2006 to 5% in June 2008 (see panel (b) of Figure 12.10)

After July 2008, oil prices fell sharply, shifting short-run aggregate supply downward However, in the fall of 2008, the financial crisis entered a particularly virulent phase fol-lowing the bankruptcy of Lehman Brothers, decreasing aggregate demand sharply As

a result, the economy suffered from increasing unemployment, with the unemployment rate rising to 10.0% by the end of 2009, while the inflation rate fell to 2.8% (see panel (b) of Figure 12.10)

The United Kingdom and the 2007–2009 Financial Crisis

As in the United States, the rise in the price of oil in 2007 led to a negative supply shock In

Figure 12.11 panel (a), the short-run aggregate supply curve shifted up from AS1 to AS2 in the United Kingdom The financial crisis did not at first have a large impact on spending,

so the aggregate demand curve did not shift and equilibrium instead moved from point 1

to point 2 on AD1 The aggregate demand and supply framework indicates that inflation would rise, which is what occurred (see the increase in the inflation rate from 2.3% in 2007

to 3.9% in December 2008 in Figure 12.11 panel (b)) With output below potential and oil

prices falling after July of 2008, the short-run aggregate supply curve shifted down to AS1

At the same time, the financial crisis after the Lehman Brothers bankruptcy impacted ing worldwide, causing a negative demand shock that shifted the aggregate demand curve

spend-to the left spend-to AD2 The economy now moved to point 3, with a further fall in output, a rise

in unemployment, and a fall in inflation As the aggregate demand and supply analysis predicts, the UK unemployment rate rose to 7.8% by the end of 2009, with the inflation rate falling to 2.1%

Application

China and the 2007–2009 Financial Crisis

The financial crisis that began in August 2007 at first had very little impact on China When the financial crisis escalated in the United States in the fall of 2008 with the collapse of Lehman Brothers, all this changed China’s economy had been driven by extremely strong export growth, which up until September of 2008 had been growing at over a 20% annual rate

from rising oil prices

shifted the short-run

aggregate supply curve

up and to the left

from AS1 to AS2 in

the United Kingdom

The economy moved

to point 2 With output

below potential and oil

prices falling after July

of 2008, the short-run

aggregate supply curve

began to shift down

to AS1 A negative

demand shock following

the escalating financial

crisis after the Lehman

Brothers bankruptcy

shifted the aggregate

demand curve to the

left to AD2 The

econ-omy now moved to point

3, where output fell to

Y3 , unemployment rose,

and inflation decreased

to π 3 The data in

panel (b) support this

analysis: note that the

then fell to 2.1% over

this same time period.

20062007

Unemployment Rate (%) Inflation (Year to Year) (%)

2.32.33.43.92.12.1

(b) Unemployment and Inflation, 2006–2009

Step 1 A negative supply

shock shifted AS upward,

increasing inflation and reducing output.

Step 2 A negative demand

shock shifted AD leftward, while AS shifted down as

oil prices fell…

Aggregate Output, Y

Inflation Rate, p

3

Source: Office of National Statistics, UK www.statistics.gov.uk/statbase/tsdtimezone.asp

Mini-lecture